Can U.S. Equity Still Deliver if the Fed Hikes?

Federal Reserve (Fed) Chairwoman Janet Yellen’s testimony to Congress this week took a big step toward making clear something investors have assumed for some time: The Fed is on course for raising interest rates. True, that leaves the question of when (most likely in either June or September, but could be later) and how much (it should be a measured affair), but a big focus for investors now is: what will be the impact on equities?

Despite the post-crisis rewards of the U.S. stock markets so far (The S&P 500’s total return is up more than 230% since the lows of 20091), investors are keenly aware that much of the rise is owed to the Fed’s extraordinary unconventional monetary policy, mainly in the three rounds of quantitative easing. Therefore it is natural to wonder, if not worry, how markets might perform as the Fed moves toward normalizing policy. Will the multiyear rally come to an end? A few things to consider:

Look beyond short term. We took a look at the last tightening cycles in 1994, 1999 and 2004, to try to get an idea of how U.S. stocks might perform when monetary policy changes direction. In each of those cycles, the S&P 500 fell -3.3%, -6.2% and -1.9%, respectively, averaging a loss of -3.8%, in the three months that followed the initial interest rate hike2. But if we expand the time horizon, the story becomes very different. For the 12 months after the first rate hike, the S&P 500 rose 4.8%, 7.2% and 6.3%, respectively, averaging a gain of 6.1%2. After the initial shock of the policy shift wore off, investors eventually returned to the markets on improved economic conditions. This is because rate hikes typically occur in the context of an improving economy. While the U.S. economy today is not fully healed, it is unquestionably improving, and it no longer requires a zero interest rate policy.

However, a big caveat is warranted: the current valuations of U.S. equities are above average, although not at “bubble” levels, as I discuss in my latest Market Perspectives paper. And some areas of the market, the so-called “bond proxies,” like utilities, are currently very expensive. Given that, stocks can move higher, even after the Fed moves, but longer-term returns are likely to be below the historical average, probably in the low to mid single-digit range.

Prepare for a more volatile market. Another development you can expect as the Fed tightens: higher volatility. Based on observations on these past tightening cycles, markets became significantly more volatile early on in the cycle, although they settled down over the longer term. In recent years, the Fed’s extraordinary easing has kept markets unusually steady, which played a big part in boosting confidence in the financial and the real economy. Yet, as the Fed takes a step back, it is natural for volatility to rise and return to more normal levels, particularly if the rate increase happens sooner than expected.

How to consider positioning portfolios. In our view, stocks in general could continue to rise despite higher volatility, and as we have advocated for some time now, for some investors, stocks may still make better investments than bonds for the longer term. We do not expect the Fed’s upcoming rate hike to have a detrimental impact on financial markets over the longer term, and for markets in Europe, Japan and select Asian emerging markets, central bank accommodation in those countries should continue to support stocks. But in the U.S., while we believe improving economic conditions should continue to support U.S. stocks over the next year, their stretched valuations make lackluster returns more probable for the next year or so.